Introduction

Ensuring that state government offers sustainable
retirement benefits will be a challenging task for Michigan policymakers. On
Sept. 30, 2010, the state had a massive, unfunded $21.7 billion
constitutional obligation to provide retirement income that has already been
earned by government employees under state government’s two largest pension
plans: the Michigan Public School Employees’ Retirement System and the Michigan
State Employees’ Retirement System.[*]

To contain these costs, policymakers have begun
transitioning some of the state’s various defined-benefit retirement systems to
defined-contribution plans.[†] An
exception to this reform, however, has been MPSERS, which is the state
government’s largest pension plan. As of Sept. 30, 2010, the MPSERS pension
plan had total actuarial accrued liabilities of $60.9 billion and an actuarial
value of assets of $43.3 billion, leaving an unfunded actuarial accrued
liability of $17.6 billion.[1]

Reforming MPSERS by shifting new employees from a
defined-benefit plan to a defined-contribution plan would further benchmark the
state’s retirement systems to private-sector norms. Yet the state has also been
warned by several analysts that this reform would result in substantial
“transition costs” the state cannot afford.[2]

It might seem that the state can neither keep its
system nor reform it — or to paraphrase Jefferson, that the state has a wolf by
the ear and can neither hold him nor safely let him go.[3]

This paper, however, explains how policymakers can
honor the commitments made to MPSERS participants while controlling and even
eliminating so-called “transition costs.”

State statutes set parameters for the retirement
benefits of all Michigan governments and government-owned entities, such as state
universities and community colleges. The state requires public school districts
to offer retirement benefits through MPSERS.[‡],[4]

Most state employees, on the other hand, receive
pension benefits through the Michigan State Employees’ Retirement System.[5] There are also separate plans for judges,
state police and legislative employees.[6]
Local governments can offer pension benefits to employees at their own
discretion.[§]

In 1996, the state
created a defined-contribution plan for all new hires who entered the MSERS
retirement system. The MSERS defined-benefit plan was closed to new
participants, though existing participants were free to remain in the
defined-benefit plan and continue earning benefits there if they chose.[7] The Legislature instituted a similar
transition to defined-contribution plans for new hires in its retirement
systems for judges and legislative employees.[8]

In the defined-contribution plans for the three
systems, the state employer automatically deposits an amount equal to
4 percent of an employee’s salary into an independent account and then
matches an employee’s personal contributions to the account up to
3 percent of the employee’s salary.[9]
The individual employee is responsible for determining how much money is placed
in his or her account, how this money is invested[¶] and how this money is used
upon his or her retirement. The state does not guarantee a particular
retirement income or incur liabilities for future payments.

These defined-contribution systems offer three major
benefits to employers. First, the plan is “current,” meaning that the costs for
retirement are paid in full on an annual basis and the employer does not risk
having to contribute more money in the future for unfunded liabilities. Under a
defined-contribution plan, costs are incurred immediately and payment of that
cost retires the employer obligation completely. In contrast, under a
defined-benefit plan, employer payments are only deposits set aside to pay a
future liability. These deposits may prove insufficient, so that further
deposits become necessary to cover the unfunded liabilities that develop.
Unfunded liabilities in a defined-benefit plan may emerge for several reasons:
investment returns that are lower than the initial predictions; demographic
patterns, such as member longevity, that diverge from initial expectations; or
future pay and benefit changes.

Second, the plan is predictable, meaning that the
employer’s costs fluctuate only with payroll and with the program’s design
parameters, both of which are under the employer’s control. The employer’s
contributions to the plan are not subject to factors like problematic
investment returns or demographics — the less predictable elements that
influence employer pension contributions in defined-benefit plans.

Third, benefits in
a defined-contribution system are usually affordable. Private-sector employers’
payments to defined-contribution plans are usually between 5 percent to
7 percent of payroll, as noted by actuary and Mackinac Center Adjunct
Scholar Richard C. Dreyfuss.[10] MSERS
defined-contribution plan, which requires state government deposits of up to
7 percent of employee payroll, is consistent with this general
private-sector range.

In contrast, current
employer contributions to the MPSERS defined-benefit pension plan are
17.39 percent or 18.62 percent of payroll, depending on when the
employee was hired.[11] This
high percentage is largely because of unfunded liabilities, which in turn
are largely due to experience that has not matched expectations and to the
state’s failure to make the actuaries’ annual recommended contributions to the
MPSERS pension fund. As noted earlier, at the end of fiscal 2010, MPSERS
defined-benefit pension plan had a $17.6 billion unfunded liability.[**],[12]

This unfunded liability suggests that the Legislature
should consider repeating its successful MSERS reform with MPSERS,
transitioning all new school hires to a defined-contribution plan. In this
transition, the MPSERS defined-benefit plan would be closed to new
participants, so that they would not increase the plan’s total liabilities and
the potential for unfunded liabilities. The MPSERS defined-benefit plan would
stop incurring further liabilities with each new hire, making it easier for
legislators to finance the unfunded liabilities owed to current employees.

And indeed, as discussed below, the current
liabilities in the MPSERS defined-benefit plan are owed to employees under the
Michigan Constitution. This does not mean, however, that reforms cannot legally
be made to retirement benefits. In fact, such reforms can ensure that the
constitutional promises are kept.

“In … defined-benefit
plans, the members’ government employer assumes the responsibility of annually
investing employer and employee pension contributions in amounts sufficient to
finance a projected annual retirement income. These plans place all of the
investment risk on the government employer — in this case, on the taxpayer.

“… In [a defined-contribution] plan, the state makes
ongoing contributions to a tax-favored account, with the employee able to
contribute as well. The employee directs investment of the monies, and the
accumulated capital is available to the individual at retirement. State
government and state taxpayers do not assume investment risk, and the plan
incurs no unfunded liability; the amount of money at retirement largely depends
on investment returns over time.”

[§] While
there are myriad local government retirement systems, the Michigan Municipal
Employees’ Retirement System covers 750 local governments and local government
entities, such as regional transit authorities. MERS was created by state law,
and it is now an independent nonprofit entity. “About MERS,” (Municipal Employees’
Retirement System, 2012), http://goo.gl/4yPnO (accessed March 4, 2012).

[¶] Specifically, the employee is free to choose
among investment options offered by an investment firm that has been approved
by the state.

[**] In order
to keep the actuarial value of MPSERS pension fund somewhat stable compared to
market fluctuations, the state uses a five-year average of the plan’s market
value. In 2007, the state marked up the plan’s actuarial value to that year’s
market value and began a new
five-year averaging process going forward from that point. According to the
most recent investment report from the Michigan Department of Treasury, the market value of MPSERS portfolio was
$37.8 billion on Nov. 30, 2011 — somewhat less than the five-year
average. “State of Michigan Retirement Systems Profile — November 2011,”
(Michigan Department of Treasury, Bureau of Investments, 2011),
http://goo.gl/IhBf0 (accessed Feb. 8, 2012).